Appeal of Report of Examination (First Quarter 1996)

Background

A bank appealed the finding in its most recent report of examination that it violated 12 USC 78 by having an investment broker serve as a director of the bank. The individual is a "retail investment executive" for a national brokerage firm. As such, he executes orders for the purchase and sale of securities on a daily basis. His responsibilities, however, are not solely limited to this function. The bank argues that the individual can serve as a bank director because the brokerage firm does not meet the 10 percent rule test and, alternatively, the individual qualifies for the "broker exception" to 12 USC 78.

Discussion

According to 12 USC 78:

No officer, director, or employee of any corporation or unincorporated association, no partner or employee of any partnership, and no individual, primarily engaged in the issue, flotation, underwriting, public sale, or distribution, at wholesale or retail, or through syndicate participation, of stocks, bonds, or other similar securities, shall serve the same time as an officer, director, or an employee of any member bank except in limited classes of cases in which the Board of Governors of the Federal Reserve System may allow such service by general regulations when in the judgment of the said Board it would not unduly influence the investment policies of such member bank or the advice it gives its customers regarding investments.

The Supreme Court interpreted the phrase "primarily engaged" in a 1947 case. In its decision, the Court held that an activity "may be primary, if it is substantial," even if it is not the largest or most important activity (Board of Governors of the Federal Reserve System v. Agnew, 329 U.S. 441, 446-47, 1947).

The Federal Reserve Board (FRB) has further defined "primarily engaged" through orders and interpretive opinions. In 1958, the FRB published a list of nine factors it would consider in determining whether an entity was primarily engaged in ineligible securities activities. These factors included the dollar volume, gross revenue, percentage volume, and percentage revenue form ineligible securities activities, the entity's market share in performing these activities, and other factors such as whether the entity had separate departments for these activities (1 Federal Reserve Regulatory Service 3-895). A 1981 FRB staff opinion provided a less complicated alternative test. Referred to as "the 10 percent rule," this opinion stated the following:

The Board generally has determined that a securities firm that receives 10 percent of its gross income from [12 USC 78] business is "primarily engaged" within the meaning of the statute (1 FRRS 3-939).

The term "ineligible securities activities" is defined as follows:

.the Board is of the opinion that when a firm is doing any significant amount of business as a dealer or underwriter, then investments for the firm's own account should be taken into consideration in determining whether the firm is "primarily engaged" in the activities described in [12 U.S.C. 78]. The division into dealing for one's own account, and dealing with customers, is a highly subjective one, and although a particular firm or individual may be quite scrupulous in separating the two, the opportunity necessarily exists for the kind of abuse at which the statute is directed. The act is designed to prevent situations from arising in which a bank director, officer, or employee could influence the bank or its customers to invest in securities in which his firm has an interest, regardless of whether he, as an individual, is likely to do so (12 CFR 218.110; see also 1 FRRS 3-939).

Thus any 10 percent rule calculations should include all of the brokerage firm's corporate securities principal transactions ---which should cover both the brokerage firm's dealing activities and its own investments.

The individual submitted a letter to the bank which seems to support the bank's revenue argument by showing that corporate underwriting generated less than 10 percent of the brokerage firm's net income. However, the individual did not include the principal transaction revenues generated by corporate securities in his net revenue calculations. FRB interpretations include underwriting, dealing, and investments for a firm's own account ---general principal transactions---in determining whether an entity is "primarily engaged" in ineligible securities activities. According to the five year financial summary in the brokerage firm's 1994 annual report, the combination of its corporate securities "underwriting" fees and corporate securities 'principal transaction" revenues accounted for more than 10 percent of its gross annual income for each of the last five years (1994: 12.9 percent, 1993: 15.9 percent, 1992: 16.7 percent, 1991: 17.8 percent, and 1990: 12.3 percent). Consequently, the brokerage firm is "primarily engaged" in ineligible securities activities.

The bank also presents the "brokers exception" found in 12 CFR 218.1, n.1. This regulation states the following:

[a] broker who is engaged solely in executing orders for the purchase and sale of securities on behalf of others in the open market is not engaged in the business referred to in [12 USC 78].

There are two primary reasons why this exception does not apply to the individual in this case. First, the individual's brokerage firm duties "are not solely limited to" broker activities. Second, even if the individual engaged solely in executing orders for others, the broker exception would still not allow him to serve as a bank director. The broker exception simply states that an individual who engages solely in broker activities is not an individual "engaged primarily" in ineligible securities activities. This exception still leaves the prohibition against employees of corporations and partnerships that do primarily engage in ineligible activities---the situation here.

Conclusion

The ombudsman concluded that the individual is prohibited from serving as a director of the bank so long as he remains an employee of the brokerage firm. However, nothing in the statute prohibits the individual from serving as an advisory director to the bank pursuant to 12 CFR 7.4110 and 1 FFRS 3-936.1. As an alternative, the bank may consider, if it desires, appointing the individual as an advisory director of the bank.

Appeal of Referral of Compliance Issues(First Quarter 1996)

Background

A bank appealed to the ombudsman for a review of an OCC decision to refer examination findings to another regulatory agency regarding certain customer transactions. In the course of evaluating the bank's compliance systems, the examiners identified several accounts raising compliance issues and these matters were noted in the examination report. The OCC initially concluded a referral was appropriate based upon these possible compliance issues. The bank was already aware of a relevant pending investigation by the other regulatory agency and was submitting documents to that agency on an ongoing basis. The regulatory agency had also previously submitted an access request to the OCC requesting examination findings and related materials.

Bank management appealed the examination findings for two reasons: (1) based on their view that a formal referral to the other regulatory agency was unnecessary and inappropriate; and (2) arguing that a referral would be inconsistent with OCC policy. Bank management considered a referral to be unnecessary and inappropriate because they contended the underlying transactions were in compliance with applicable standards. The bank contended the examiners never made a final determination that the transactions in question were in fact noncomplying. Bank management also considered a referral to be inconsistent with OCC's referral policy. The bank contended that in the absence of a finding by the examiners that a law was violated, a referral to another regulatory agency was not appropriate.

Discussion

The OCC's examination policy in this compliance area is first to assess whether systems are adequate. In order to make this determination, examiners typically sample and review transactions. If those files are incomplete, examiners customarily request additional information from the bank. These procedures were followed in this case. During the coursework of reviewing certain files, the OCC examiners identified several files that raised compliance issues. The examiners did not reach any definitive conclusions concerning these transactions. These transactions were noted in the examination report as raising compliance issues. Criticisms of the bank's overall compliance systems were also noted more extensively in the examination report.

Conclusion

The ombudsman decided that the supervisory office should remove certain language from this examination report that raises questions about compliance in individual transactions because the examiners did not reach any final conclusions concerning those accounts. The language in the examination report that criticizes the bank's systems and controls will remain. Therefore, removal of the language about individual transactions from the examination report does not in any way undermine or lessen the examining team's criticism of the bank's compliance practices. Documentation and analysis of these criticisms will also remain in the work papers.

The ombudsman determined there is no reason to formally refer the examination report to the other regulatory agency because the OCC will provide it and any other relevant exam information to that agency pursuant to its pending access request.